Building a Program: Financial Economics

When Jaksa Cvitanic, Caltech's Richard N. Merkin Professor of Mathematical Finance, joined the faculty in 2005, he was a bit of an outlier. Caltech had a strong economics program, including a popular business and economics management option for undergraduates. But Cvitanic's research focus—financial economics, a branch of economics that studies financial markets, firms, and corporate financial decision making—was not well represented. Indeed, there was only one other faculty member doing similar research.

To Cvitanic, this was an opportunity: "The fact that I was somewhat isolated, as far as interest in finance goes, turned out to have positive consequences—it made me spend more time learning new things from my Caltech colleagues and collaborating with them," he says. "Ten years ago, I would not have guessed that I would be carefully reading research papers on neuroeconomics or political science, or that I would coauthor papers that involve experimental economics, as I have with Peter Bossaerts [a visiting associate and formerly Caltech's William D. Hacker Professor of Economics and Management and professor of finance] and Charles Plott [Caltech's William D. Hacker Professor of Economics and Political Science]."

Over the past three decades, financial economics has become an increasingly important academic field. While it borrows many tools and principles from economics, financial economics deals specifically with monetary activities—pricing, money flows, interest rates—rather than the factors governing the relationship of supply and demand. Its practitioners have produced innovations with real-world applications, such as stress tests for financial institutions and mathematical models to determine the pricing of risk and the valuation of future cash flows.

Financing can be done today in much more flexible and efficient ways than 30 years ago, partly due to innovations rooted in financial economics. Concepts such as mortgage securitization, interest rate swaps, and money market funds originated in academia during the 1970s as economists sought to combat the effects of that decade's recession. Recognizing the importance of this area to both academia and society, Caltech is developing a curriculum around the study of finance.

"Finance has long been a career where Caltech undergraduates and graduates have excelled, and we plan to offer the same research-based education that students can receive in other areas," says Jean-Laurent Rosenthal (PhD '88), the Rea A. and Lela G. Axline Professor of Business Economics and chair of the Division of the Humanities and Social Sciences. "Financial economics is important simply because our societies have become very capital intensive."

At the foundation of these efforts is The Ronald and Maxine Linde Institute of Economic and Management Sciences, Caltech's hub for research and education in business and economics, funded in 2011 by a gift of $12.3 million from trustee Ron Linde (MS '62, PhD '64) and his wife, Maxine. Financial economics has ties to diverse fields, including behavioral economics, neuroeconomics, applied mathematics, and computer science. These are fields in which Caltech traditionally excels, providing Linde Institute researchers with unique opportunities for interdisciplinary studies.

At Caltech, researchers take a rigorous analytical and statistical approach to finance. "There is no business school at Caltech, so the finance group is much more of a research area than a teaching place for MBAs and similar career-focused students," says Linde Institute Professor of Finance Richard Roll. Because of this approach, Roll says, students who originally trained in other disciplines, including physics and mathematics, are attracted to financial economics at Caltech.

Many of these former students, now with successful careers in finance, were attendees at the Linde Institute's "Caltech + Finance" inaugural symposium, which took place on May 1, 2015. The symposium, organized by Roll, opened with welcoming remarks from Ron Linde and featured three distinguished alumni speakers—Robert J. Barro (BS '65, physics), the Paul M. Warburg Professor of Economics at Harvard University; Nobel Laureate Robert C. Merton (MS '67, applied mathematics), the School of Management Distinguished Professor of Finance at MIT; and trustee Stephen A. Ross (BS '65, physics), the Franco Modigliani Professor of Financial Economic at MIT—who offered their insights as leaders in business finance and scholars of financial economics.

Meanwhile, the diverse academic training and interests of Caltech's finance students can steer the faculty into new research areas. Cvitanic, for example, says that an undergraduate student-run "quantitative finance" group interested in algorithmic trading (in which trading is done using algorithms that execute pre-programmed instructions in response to particular variables like stock price and volume) and high-frequency trading (a type of algorithmic trading) coincided with his own interest in the area, and spurred him to write a paper on the topic.

Well-functioning economic systems are essential to successful economic growth. As those systems grow more complex, interconnected, and global, understanding how they function—and how they might function better—is increasingly important. Moreover, when shocks to economic systems occur, such as the Great Recession of 2008–09, all of the tools of scientific and financial innovation are needed to get markets back on track. "Caltech has long trained its students to be great problem solvers, to navigate complex systems, ask the right questions, and find innovative ways to address problems in science and engineering. With the Linde Institute we are making great strides to do the same for financial markets," says Rosenthal. Recent graduates in business, economics, and management have gone on to work in academic, corporate, and government sectors; some have joined investment banks, trading firms, consulting companies, hedge and investment funds, and regulatory agencies, and others have established their own businesses, or earned PhDs, or both.

"We bring the brightest students on the planet to study at Caltech, and we should be empowering their curiosity and talent wherever they lead," Rosenthal says.